When insider trading hits the news, it is usually the illegal kind, and investors take notice.  Understanding why illegal insider trading is illegal will give you a better understanding of the market – and how it can impact your portfolio.

The dirty secrets of insider trading

Insider trading occurs when a stock trade is influenced by someone that has access to corporate information that the general public does not have.  This privy information is usually used by investors who are hoping to gain an unfair advantage.  Using this information goes against the fundamental basis of the market: transparency.  In a transparent market, information is distributed in such a matter that everyone receives it at more or less the same time.  This means that the only way to gain an advantage is through analyzing and interpreting information.  Insider trading is unfair, since one person not only obtains an advantage of information, but also potentially disruptive to the market.  Too much insider trading and the “disadvantaged” investors would lose confidence and stop investing.

Working against insider trading

In 2000, the Securities and Exchange Commission developed new rules regarding inside trading.  Under the new ruling, the SEC labels insider trading as a transaction made when the person making the transaction is aware of information that has not been made public and is violating the duty to keep such information confidential.

The definition of “information” for this regulation is material that might affect the price of the company’s stock if released.  For example, this might include:  an announcement of a tender offer, a merger declaration, announcement of positive earnings, discovery of a new product, and more.

For additional limitations to insider trading, the SEC also said that companies can no longer be selective as to the release of information.  Thus, analysts and institutional clients cannot receive the information prior to the general public.

For insider trading, an insider can be anyone who has access to the information that has not been released to the public.  CEOs, executives, and directors are obviously at the top of this list.  Other relationships are also subject to confidentiality.   These are:  if a confidentiality agreement exists, when a relationship has a history or pattern of mutual confidentiality, and when a person hears information from a family member.

Sometimes, insider trading can be the result of an information leak outside of the company.  The tipper is a person who has consciously or unconsciously given away inside information, and the tipped is someone who uses this information to make a trade in their favor.  However, this link can be difficult to prove, since the route information takes is not always easy to track.  In some cases, a person can be accused of a crime just for overhearing confidential information and using it to make a trade.  The person who inadvertently leaked the information may or may not be able to be held responsible.

Insider trading often is the result of chance, not skill, and can be very damaging to the market.  It can influence the market to such a degree that you, the average investor, are at a disadvantage in making trades with that company.   This is why it is important that all insider information be kept strictly confidential within the company until released to the general public.